A Lethal Shakeout

"If, as I suspect, the American consumer now enters a sustained slowdown, there will be unmistakable reverberations on U.S.-centric export flows in many major regions of the world." -- Stephen S. Roach, October 2006

Before the year is over, no major region of the world will remain unscathed by recession. Indeed, I suspect that 2009 will go down in history as the first truly global recession of the modern economy.

Yes, it began in the United States in the summer of 2007 with the so-called subprime crisis. But there were bubble-dependent growth models in a surprisingly large number of countries — all now bursting.

In the United States, asset-dependent growth was concentrated in two parts of the economy: home-building activity and personal consumption. Sustained weakness is now likely in both sectors, which at their peak accounted for nearly 80 percent of U.S. GDP.

That brings export-dependent Asian economies into the equation. In effect, they were driven by export bubbles, which, in turn, were a levered play on the U.S. consumption bubble. Asia was also aided and abetted by sharply undervalued currencies. And to keep their currencies cheap, countries such as China had to recycle massive amounts of foreign exchange reserves into dollar-based assets — suppressing U.S. interest rates and sustaining the very asset and credit bubbles that fueled a bubble-dependent U.S. economy. That virtuous circle has now been broken. And because Asian economies lack vigorous support from internal private consumption, regional growth risks have tipped decisively to the downside.

A similar verdict is likely for the commodity-producing regions of the world — not just the oil-dependent Middle East, but also the resource-intensive economies of Australia, Canada, Brazil, Russia, and Africa. As global growth slows, so does the demand for economically sensitive commodities — resulting in a sharp correction in the bubble-distorted commodity prices and growth rates of the major commodity producers.

A second megaforce at work is globalization — the cross-border linkages that during the past decade have increasingly taken the form of trade flows, capital flows, information flows, and labor flows. The credit crisis itself is essentially a powerful cross-product contagion — a virus that began with subprime mortgages but then quickly spread to asset-backed commercial paper, mortgage-backed and auction-rate securities, and other instruments throughout the credit markets. But because financial engineers were so adept at distributing the complex products they created, there is a critical cross-border dimension to this crisis as well. Little wonder this is the worst financial crisis in 75 years.

Driven by the confluence of post-bubble shakeouts and increasingly robust global linkages, this recession is likely to be the worst of the post-World War II era. That means it could be more severe than the sharp downturns of the mid-1970s and early 1980s. Back then, it was the aggressive anti-inflation resolve of central banks that led to deep recessions. This time, an implosion of bubble-dependent global imbalances has done the trick.

But don’t count on a vigorous (V-shaped) rebound from the post-bubble global recession of 2009. With no other major consumer likely to step up and fill the void left by the United States, a lopsided, bubble-distorted world will experience an anemic recovery at best. It will be a long time before global growth returns to the nearly 5 percent rate of the four and a half years that ended in mid-2007. Post-bubble shakeouts are lethal for any individual economy — to say nothing for the world as a whole.

Stephen Roach is a Senior Fellow at Yale University’s Jackson Institute of Global Affairs and a Senior Lecturer at Yale’s School of Management.

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